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GUETERSLOH, Germany (Reuters) - Two years ago voters in this industrial city on the eastern edge of North Rhine-Westphalia (NRW) narrowly backed German Chancellor Angela Merkel's conservatives in a regional election.

But next month, voters like Jochen Venker may vault the rival Social Democrats (SPD) into first, strengthening the centre-left party's hold on Germany's most populous state and dealing Merkel a heavy blow before a federal vote in 2013.

Venker, a 65-year-old retiree who came with his wife Brigitte to the central market square in Guetersloh last Thursday to hear regional SPD leader Hannelore Kraft speak, applauded her message of moderation in cutting the state's big debt mountain.

"Saving is fine but it shouldn't be overdone. Just look at Greece - it's proof that debt reduction alone doesn't work," said Venker, a short man with glasses and a bristly beard.

"I worry that if we push consolidation too far, people will lose hope, they'll radicalise, there'll be a move to the right. We saw that before in Germany and it was a disaster."

Voters like Venker are Merkel's worst nightmare, not only because they could give Kraft a decisive victory over her conservative rival Norbert Roettgen in an election on May 13, but also because of the message that result would send to Germany's struggling partners in the euro zone.

Under Merkel, Germany has forced high-debt countries like Greece, Ireland and Portugal to accept painful austerity as a condition for financial aid. Spain and Italy are also making unprecedented budget cuts in a desperate bid to avoid bailouts.

But in NRW, a rust-belt state whose debt has swelled to a record 180 billion euros ($237.74 billion), the electorate is rejecting Merkel's message of fiscal responsibility and embracing the SPD's go-slowly approach, which promises investments in children, education and NRW's ailing cities.

"If we want countries like Greece and Portugal to take budget discipline seriously, then we need to take it seriously in a big state like North Rhine-Westphalia," said Juergen von Hagen, an economics professor at Bonn University.

"Right now it isn't being taken seriously. Germany is imposing austerity in other countries that is not being accepted at home."

MINI FINANCIAL CRISIS

With nearly 18 million residents, NRW has a bigger population than the Netherlands, with which it shares a border, and an economy almost as big.

It is home to one-third of Germany's blue chip companies and four of the country's nine biggest cities.

In 2005, the state's influence on national politics was underscored when a loss for the SPD here prompted then-Chancellor Gerhard Schroeder to call an early federal election, which he ended up losing to Merkel.

This time around, the SPD is hoping to return the favour, building momentum it needs to deny Merkel a third term.

In the decades after World War Two, the coal and steel plants of NRW's Ruhr region helped fuel Germany's economic miracle. But the collapse of these industries has hit the state hard.

Unemployment stands at 8.2 percent, not high by European standards, but more than a full percentage point above the national average and double the rate in rich southern states like Bavaria and Baden-Wuerttemberg.

In Ruhr cities like Gelsenkirchen, Duisburg, Dortmund and Essen joblessness has pushed up to between 12 and 15 percent - worse than in all but the hardest hit areas of eastern Germany.

Energy firms like Essen-based RWE were upended by Merkel's decision to phase out nuclear energy and a big Opel car plant in Bochum could be closed by parent General Motors.

"NRW is not just the Ruhr," said Michael Huether, president of the IW economic institute in Cologne.

"It is a highly industrialised state with strong companies in the machinery, automotive, chemicals and energy sectors. The problem is that you have regions on very different economic trajectories that have not been linked up."

The impact of the economic woes on local finances has been devastating. On top of the 180 billion euros in state debt, municipalities have amassed liabilities of nearly 50 billion.

Only eight of the 396 local governments in NRW have balanced budgets, putting the state at the centre of a mini-financial crisis that has gone largely unnoticed due to the overall strength of Europe's biggest economy and the health of finances at the federal level.

One of the worst hit areas is Oberhausen, a city of just over 200,000 where its last coal mine and a large Thyssen iron and steel mill shut down in the 1990s.

Since then, it has tried to transform itself into a service-based economic hub, opening what the city hails as "Europe's biggest shopping and leisure centre" on the site of a shuttered steel production plant.

But the results have been disappointing and Oberhausen now holds the ignominious distinction of being the city with the highest debt per capita in Germany. In a twist, its treasurer, Apolstolos Tsalastras, is the son of Greek immigrants.

With its debt set to rise above 2 billion euros, Oberhausen's SPD Mayor Klaus Wehling told Reuters he was working on a long-term budget plan that foresees annual savings of 40 million euros over the next decade.

Last month, Wehling joined three of his counterparts in the Ruhr to demand an early end to the post-reunification "solidarity pact", under which state and local governments in the west provide funds for rebuilding the former-communist east.

"The economic situation in parts of NRW is much worse than it is in many regions in the east," Wehling said in a telephone interview.

CARING MOTHER

Strengthening stricken cities like Oberhausen is one of Kraft's main campaign promises, although it is unclear how she would find the funds to do this without federal help.

The 50-year old daughter of a tram-operator who grew up in the heart of the Ruhr valley, Kraft has run a minority government with the Greens in NRW for the past two years, but was forced into an early election when she failed to get her 2012 budget through the state assembly in March.

A supplementary budget introduced by her coalition after it took power was ruled unconstitutional by a state court, opening her up to accusations of fiscal mismanagement.

Von Hagen at Bonn University said if Kraft was re-elected, NRW was unlikely to deliver on its promises under Germany's "debt brake" law, setting a dangerous precedent for other regions of Germany and Europe as a whole.

But people in Guetersloh dismissed those concerns and praised Kraft as an honest, down-to-earth politician who had the state's best interests at heart.

She reinforced that image during a short walk through the pedestrian zone in the city centre, where she handed out roses, stopped to talk to residents and gave a five-euro note to a beggar trying to raise money for an electric wheelchair.

"We will look closely at where we can save," she told a crowd of 100,000 in the city, home to the German media group Bertelsmann and appliance maker Miele. "But the lawnmower approach to cutting has been tried before. Simply slashing jobs doesn't work," she said to cheers.

The message from Kraft's intimate campaign event stood in stark contrast to the one sent at a rally by her Christian Democrat (CDU) challenger Roettgen - who is also Merkel's environment minister - several days before.

On the central Domplatz square of the affluent university town of Muenster, the CDU erected a huge inflatable "debt mountain", a physical reminder of what it called the dangers of re-electing Kraft.

To thumping house music, Roettgen and his special guest Merkel pushed through the throng like boxers before a title bout and, once up on the stage, took shots at their opponent.

"Look around Europe at what has happened," said Merkel. "Countries have been forced to accept the toughest of measures. They are so dependent on financial markets that they can no longer decide for themselves.

"We in Germany and the politicians of this state need to ensure we can shape our own future, we need to watch out that our borrowing costs don't rise so high that we can't make decisions. This is what's at stake."

Voters do not seem to be heeding the warnings. The latest opinion polls show Roettgen's CDU trailing Kraft's SPD by 6-8 percentage points.

Kraft has cultivated the image of a "Landesmutter", or caring mother figure for the state, in her two years in power. Some in the SPD even see her as a potential challenger to Merkel next year if she wins big in her home state next month.

Roettgen has angered many voters by refusing to commit to being a full-time opposition leader in the state capital Duesseldorf if he loses next month. That would mean giving up his cabinet job in Berlin.

Roettgen's only hope of denying the SPD and Greens a majority on May 13 may rest on strong showings by the struggling Free Democrats (FDP) and upstart Pirate Party.

"If you ask Germans whether they want debt reduction, then the vast majority say yes. After the hyper-inflation of the 1920s they have a visceral reaction to living above their means," said Klaus-Peter Schoeppner, head of the Bielefeld-based Emnid polling group.

"But the CDU hasn't been able to score points with this theme in NRW. Kraft is telling people that the investments of today are the debt brake of tomorrow. She is promising a softer approach and that's what people seem to want."